This is somewhat of a no brainer for many with a bit of spare cash left over. You are either looking to bring down the term of the mortgage, so it is paid off quicker or your repayments in general. So, is this a good idea?
How does it work?
Mortgage interest rates have been their lowest for years at the start of the pandemic and many people took that opportunity to remortgage, snapping up a super low interest rate in the process.
Your interest rate is the percentage annual rate of interest that the bank or building society will add to the loan each year. So, the lower the interest rate, the lower you will repay over the term of the mortgage. An example of two mortgages for £100,000 over 25 years are below:
- £100,000 borrowed at an interest rate of 2% over 25 years will have a total repayment value of £127,156 and monthly repayments of £424.
- £100,000 borrowed at an interest rate of 4% over 25 years, will have a total repayment value of £158,351 and monthly payments of £528.
Mortgages tend to work by your repayments including an element of interest and an element of capital (the original loan and the amount by which the interest is calculated on each year). Gradually, over time you will be paying more and more of the capital loan off and as your loan decreases, so do your annual interest payments.
However, overpayments are entirely paying off the capital (original loan) and do not include interest, as this is already calculated in your monthly payments. Reducing either your mortgage term or repayments as a result. So, an overpayment will directly reduce the amount of interest you will pay.
Is this a good idea?
The question is one of opportunity cost. Yes, it’s great financially to reduce your mortgage as whatever your overpayment is, you will no longer be paying your interest rate on that sum of your mortgage.
However, when your interest rate is low, like 2%, and investments like those in the ‘mixed investment 40-85% equity’ sector, have achieved 6.5% annualised return over the last 10 years, you would have been better off 10 years ago investing in the market, rather than overpaying your mortgage, by a gross 4.5% each year.
So, if you are considering making an overpayment but perhaps wanted to hear a little more about the alternative…
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